Bond villain: lessons from a $900m fixed income drama

October 1, 2017

Christian Hawkesby: Harbour Asset Management head of fixed income

Retail investors in the popular September 2007 Rabobank bond issue will emerge shaken – but perhaps better-educated – when they finally disembark from the fixed income roller-coaster ride of the decade later this week, according to a new Harbour Asset Management report.

The Harbour study says investors in the Rabo bond, which pulled in a then record $900 million from retail punters, experienced both the peaks and troughs of fixed income markets.

Launched on the eve of the global financial crisis (GFC), the Rabo bond annual coupon fell from almost 9.5 per cent in its inaugural year to just under 2.9 per cent in 2016.

The Rabo issue, reset every October 8 at a 0.76 per cent premium above the one-year NZ swap rate, fell dramatically over the 2008 to 2009 years from about 7.5 per cent to 4.1 per cent as GFC panic triggered monetary slash-and-burn responses.

“Put simply, investors had been directly exposed to interest rate risk, and felt the brunt of global interest rates falling to levels that were unanticipated before the GFC,” the Harbour analysis says.

Furthermore, the report authored by Christian Hawkesby and Mark Brown – Harbour fixed income head and portfolio manager, respectively – says many investors baled out of the, potentially perpetual, Rabo bond as it sunk to as low as 75 cents (from an issue price of $1) on secondary markets over 2007-2009.

“Some sellers may have needed the proceeds for personal reasons; but many others probably sold as nerves won over after observing others selling, and weighed out the chances of further losses,” the study says.

While the Rabo bond will be repaid this month on its ‘first call’ date, the bank was under no obligation to pay investors if it needed the principal to prop up regulatory capital.

“Ultimately, it was a decision of the issuer in conjunction with the bank regulator and not something that could be controlled by the investor,” the Harbour paper says.

The, possibly traumatic, 10-year Rabo bond (tagged RBOHA) experience highlights three major lessons for fixed income investors, according to the report.

“The first lesson is to know your investment,” the study says.

“… fixed interest securities may sound more straightforward [than equities], in practice they can be far more complex. There are a multitude of features that can influence their value, including whether they have fixed or floating coupons, a fixed maturity or variable call date, are secured by other assets or unsecured and if they are senior to other debt-holders or unsubordinated.

“All of these factors can matter, especially during times of stress in financial markets.”

Secondly, the Harbour report says investors need to be aware of behavioural finance biases that can “cloud” rational decision-making processes.

“One of these is the aversion we have to experiencing losses; another is following herd behaviour over making a cold, hard analysis of the facts,” the study says.

Finally, the volatile trajectory of the Rabo bond illustrates the need for fixed income investors to diversify rather than relying on just one or “a handful” of securities.

“… true diversification in a fixed interest portfolio requires holding securities across a range of issuers, sectors, maturities and security types,” the report says. “In a New Zealand context, a fixed interest fund would typically hold 80 to 100 securities, across 30 to 50 issuers.”

And with fixed income markets in a totally different state compared to September 2007, Rabo investors will have to carefully consider options as the $900 million of capital flows back into their collective wallets from October 8.

“In a world of low yields and interest rates, they will face one remaining question of how best to put their principal back to work to generate income,” the Harbour report says.